Credit unions, just like any other business these days, are faced with increasing costs related to employee benefit plans, particularly welfare benefits.

The desire for credit unions to utilize NCUA §701.19, “Benefits for employees of credit unions,” to broaden diversification among investible assets and achieve attractive risk-adjusted returns is on the rise. Institutional life insurance, which has contractual guarantees to protect against volatility of cash values (e.g., guaranteed minimum crediting rates), has been a popular investment over the past several years, but what about other alternatives?

Securities products, such as mutual and exchange-traded funds, are abundant and can be a valuable contribution to a diversified portfolio, but many credit unions have difficulty with the due diligence, implementation and ongoing administration of this type of investment program. Common concerns include:

where to begin;

how to evaluate and choose proper levels of risk; and

how to manage risk going forward.

The following discussion is focused specifically on establishing an institutional asset management program that uses non-insurance based, marked-to-market investments to offset qualifying employee benefit expenses, but does not contemplate specific investments, asset classes or allocations to use. Importantly, investment selection should be based on a CU’s specific situation. As such, recommendations on particular investments can only be made after an analysis of the goals and objectives of the program.

Getting Started

The first step is to understand how regulators view “otherwise impermissible investments” and risk. NCUA Section 701.19 provides that a federal credit union may purchase “an investment that would otherwise be impermissible if the investment is directly related” to the underlying obligation,” such as a 401(k) match or health insurance expenses. For instance, Section 701.19 allows credit unions to use the investment return from otherwise impermissible assets to cover a portion of its expense to provide the 401(k) match.

Under Section §701.19, investment income is directly related to the underlying benefit expenses so long as the investment income is less than or equal to such expenses. NCUA regulators, however, have also interpreted the DR Test to place additional restrictions on the investments, favoring investments that are more conservative, have predictable returns, and are not complicated. These investments must also be safe and sound, and well understood by the board.

The nature and timing of investment income very much depends on the type of investment; however, the most common way a CU can recognize income is through dividends and realized capital appreciation.

Evaluating Risk

To assist CUs and examiners with managing risk, NCUA designed seven risk categories to evaluate the risk profile of a credit union. The risks are divided into two groups. The first group includes three kinds of risk—credit, interest rate and liquidity—that can be evaluated using objective financial data. The second group includes transaction, compliance, strategic and reputation risk, those that are more subjective and evaluated through controls and risk management. Credit unions should review and analyze how proposed investments will impact each of the seven risks.

When considering investments that are marked to market and subject to loss of principal, credit unions must be prepared financially (i.e., values fluctuate) as well as organizationally to address the additional risk and regulatory scrutiny. A credit union that is at least adequately capitalized (i.e., having a net worth ratio of at least 6 percent under the current risk-based net worth system and, at least 8 percent for complex credit unions under the proposed risk-based capital rules) would typically have the mindset and support from its board to properly manage an institutional asset management program.

“Risk is not necessarily a negative term. In the financial world, it is a necessity. NCUA does not seek to eliminate risk in credit unions; rather, we want to ensure risks are managed at appropriate levels, given the structure and net worth of the institution.”

For many credit unions, a risk-free investment portfolio is not an option, creating the need to tolerate an appropriate amount of risk. Although determining the level of risk can be difficult, one way to approach the issue is to closely evaluate each benefit expense. Key questions include:

What do the benefit programs currently cost?

At what rate do we project benefits costs will increase?

What is a reasonable expected rate of return?

This process helps to set workable metrics for the amount of total investment, manage volatility, and anticipate the impact to the bottom line. This sets the stage for designing a successful asset management program.

Ongoing Risk Management

Perhaps the most crucial element to a successful institutional asset management program is to ensure ongoing compliance with all regulations, establish a documented due diligence process, and formalize risk and control procedures.

The key steps to take are:

updating the credit union’s investment policy statement for institutional asset investments , either as a separate statement or as an addition to the current statement;

assigning program responsibilities to executive management/board members for program oversight; and

To assist with these responsibilities, credit unions may want to engage a compliance consultant to assist the board.

Institutional asset management can be a valuable investment alternative, but given the additional complexity and risk, credit unions must do their homework and be prepared for additional regulatory scrutiny.

Kraig Klinkhammeris director of investment management at CUES Supplier member Burns-Fazzi Brock, Charlotte, N.C. He is responsible for the oversight of BFB’s institutional insurance and asset management programs.